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Thursday, August 7, 2008

National Photo Company Born To Run circa 1928 "Washington, D.C.: Boys standing next to automobile." A Ford with congressional plates.

Ilargi: The system is going through a last round of tests. The players feel pretty secure that it’s leak-proof, but they want to be certain.

Once the final tests are done, we’ll see a system emerge into the open that closely resembles the symbiosis of corporate rule and political power advocated by Mussolini: "Fascism should more properly be called corporatism because it is the merger of state and corporate power."

The system controls itself; there is no outside intervention possible after all the leaks are sealed. Hence we see a blank $800 billion check donated by Congress to the Treasury, which will be used to cover gambling losses of the corporations.

The Treasury, in turn, then hires one or more of the main corporations to help it decide how the loot shall be divided among the corporations. It won’t be for saving the share price of Fannie and Freddie.

Thirdly, the financial corporations, united in the Counterparty Risk Management Policy Group, published a report named "The Road to Reform", which examines how best to get rid of the $700+ trillion in derivatives that threatens the existence of the players.

As Washington and Wall Street will soon have become a completely developed two-headed animal, these losses also will be transferred to the public vault. Taking hold of the last large chunk of public money, the pension funds, is the next step the two heads are planning.

And as much as one may hope that Henry Waxman’s investigation of the White House as an active player in bringing down Fannie and Freddie will succeed, the chances are as infinitesimal as the amount of information that returns from a black hole.

Rep. Henry A. Waxman (D-Calif.), chairman of the House Oversight and Government Reform Committee, has asked the mortgage finance giants Fannie Mae and Freddie Mac whether they know of any White House involvement in the recent decline in their share prices.

In a letter dated Aug. 1, Waxman told Freddie Mac chief executive Richard F. Syron that he was "evaluating" whether to "open an investigation into the circumstances that precipitated the recent distress in the shares prices of Freddie Mac."

The letter asks for documents "relating to any actual or rumored disclosure or communication by a White House official to investors, the media, or board members of a plan to nationalize, place in conservatorship, or assume control of Freddie Mac."

The letter, obtained yesterday by The Washington Post, does not identify the White House official. A similar letter was sent to Fannie Mae's chief executive Daniel H. Mudd, a company spokesman confirmed.

Waxman has been a regular irritant to President Bush on issues ranging from the leak of a CIA officer's identity to the development of U.S. policy on greenhouse-gas emissions. He has been rebuffed by the White House on numerous occasions when he sought assistance on these and other topics.

A committee spokeswoman declined to comment on the requests to Fannie Mae and Freddie Mac, as did a Freddie Mac spokesman. Tony Fratto, a spokesman for President Bush, said Waxman has not contacted the White House. "It's been clear that what we have been focused on is shoring up Fannie Mae and Freddie Mac and instilling confidence in them, and that's all," he said.

Waxman and his committee staff often request information about topics of interest before deciding to open a full-scale probe. Sometimes the answers to those initial inquiries dissuade Waxman from looking further, people familiar with the committee's methods said.

Fannie Mae and Freddie Mae are federally chartered, shareholder-owned companies that help finance home mortgages. Yesterday, Freddie Mac, based in McLean, reported a $821 million loss in its second quarter. Analysts expect Fannie Mae of the District to report a second-quarter loss Friday.

The sharp declines in the shares of both companies prompted Congress and the Bush administration to agree that the government would prop up the companies if they faltered. President Bush recently signed legislation that would permit the Treasury Department to make unlimited loans or equity investments in the companies if they needed such support.

Waxman is seeking documents for the period July 1 though July 31, according to the letter. During that time, Freddie Mac's share price dropped by 50 percent to $8.17 from $16.21. Fannie Mae's shares fell to $11.50 from $19.59, a 41 percent decline.

The Treasury unveiled its rescue plan for the companies on July 13. In the previous week, several major news outlets reported that Bush administration officials were so concerned about companies that they were discussing what they might do if the firms needed to be saved. Among the options reported were those listed in Waxman's letter. Waxman said in the letter that he wanted the documents by Aug. 15.

JPMorganChase, Citi, Cerberus, and Morgan Stanley lobby Washington to let them take over and run corporate pension funds

The folks who brought you the mortgage mess and the ensuing hedge fund blowups, busted buyouts, and credit market gridlock have another bold idea: buying up and running troubled corporate pension plans. And despite the subprime fiasco, some regulators may soon embrace Wall Street's latest scheme.

The Treasury Dept. on Aug. 6 offered a blueprint for lawmakers on Capitol Hill to allow "financially strong entities in well-regulated sectors" to acquire pension plans, after the IRS ruled that the concept needed legislative approval.

"The Administration's proposal says these deals should only be permitted when the acquiring entity has a higher credit-rating than the seller," says Charles Millard, director of the Pension Benefit Guaranty Corp. (PBGC), the federal insurer of last resort of corporate pension plans. "Such a transaction creates greater security for retirees and the pension system." The issue will now, no doubt, move to Congress after the election.

In preparation for that moment, the world's biggest big investment banks, insurers, hedge funds, and private equity shops have been quietly laying the groundwork for such deals over the past year. They would be a big prize for Wall Street. The $2.3 trillion pension honey pot has $500 billion in "frozen plans" that are closed to new employees and whose benefits are capped, including those at IBM, Hewlett Packard, Verizon, and Alcoa.

And that figure could triple by 2012, according to consulting firm McKinsey. By managing those troubled plans, Wall Street also gains entrée to an appealing set of customers to whom it can sell a broad array of fee-generating products. "We have identified several clients who would be willing to be first to sell a plan," says Scott Macey, a senior vice-president at Aon Consulting. "But the question is, when is a good time for this?"

The concept of off-loading pension funds sounds great. For businesses it's a chance to rid themselves of struggling plans, which can weigh down a balance sheet. It's especially good timing now. New accounting rules take effect in the next year or so that will require companies to mark their pension assets to prevailing market prices each quarter—a change that could devastate some companies' profits.

Meanwhile, many companies no longer want to pay for pensions, troubled or otherwise. A recent report from the U.S. Government Accountability Office found that most companies freeze their pension plans merely to avoid "the impact of annual contributions to their cash flows."

But the gambit to turn pensions into for-profit enterprises raises troubling questions. Critics, including some on Capitol Hill, worry that financial firms don't have workers' best interest at heart, which would put some 44 million current and future retirees at risk. "We think it's just a terrible idea," says Karen Friedman, policy director for advocacy group Pensions Rights Center. "In the wake of the subprime crisis, it would be crazy to allow financial institutions to manage these plans."

Historically, pension funds have been managed conservatively, in keeping with the broad goals of long-term wealth accumulation. Alternative investments such as hedge funds, derivatives, and asset-backed securities represent less than 25% of pension assets. If financial firms get involved, exotic investments could swell to 50% of pensions assets by 2012, predicts McKinsey.

The biggest fear is that Wall Street could use retirement portfolios as a dumping ground for its most toxic and troublesome investments. It's not unlike what regulators allege UBS officials did with its stockpile of risky auction-rate securities by trying to off-load them to wealthy clients.

If Wall Street gambles with those pension assets and loses, U.S. taxpayers would probably foot the bill. When a company with a pension goes belly up today, the PBGC, under federal law, has to take on the fund's obligations and dole out money to its beneficiaries. It's a costly burden: The PBGC currently runs a $14.1 billion deficit.

Former PBGC director Bradley Belt argues that pension buyouts could actually strengthen the agency. If financially strapped companies could dump the plans rather than ponying up money for them, they might stay out of bankruptcy. That would mean the PBGC wouldn't have to step in and pick up the pieces of the pension.

"While there are legitimate regulatory and policy considerations, much of the criticism is misplaced," says Belt, who two years ago teamed up with private equity firm Reservoir Capital to form Palisades Capital Advisors, a pension buyout boutique. "This is really in the public interest if it's done correctly."

The federal agencies that oversee the nation's pension system are expected to weigh in on the issue—potentially paving the way for big firms that have been pursuing it, such as Aon, Cerberus Capital Management, Citigroup, JPMorganChase, Morgan Stanley, and Prudential. JPMorgan has been particularly active in this crusade, sending a letter in September 2007 to several federal agencies with its own "guidelines for pension transfers."

The Government Accountability Office, which began studying the proposal at the behest of the Congress, plans to issue a report later this year. The biggest regulatory kink that needs to be ironed out is a tax one. Under federal pension laws, an employer can deduct part of its pension plan contributions.

But it's unclear if banks or private equity firms that buy the plan would get the same tax break since they don't technically employ the workers. Squashing that perk could make such buyout deals less appealing to Wall Street. Sources familiar with the situation say the Internal Revenue Service is expected to offer a dim view of extending the current tax break to purely financial buyers. The Bush Administration is likely to take a different stance, favoring such deals in certain circumstances.

Regulators are almost certain to put the kibosh on buyouts by free-standing, independent firms that aren't tied to the books of any big firm. The worry is that such a weakly capitalized company wouldn't have the balance sheet heft to deal with the pensions if their assets soured. After all, even big Wall Street firms have been crippled by the $400 billion in subprime related losses.

Belt, a former top aide to presumptive Republican Presidential nominee Senator John McCain, had pushed a similar vehicle to make buyouts. The proposal created controversy in the industry. In its letter to regulators, JPMorgan took pains to distance itself from the strategy shopped around by Belt and other private equity firms.

The bank's legal team recommended that regulators green-light buyouts only by "institutions and structures that are well regulated" and "subject to high standards of financial strength and stability." Although any restrictions by the federal government could dampen the spirits of the buyout brigade, Wall Street are likely to simply follow the lead of financial firms in Britain.

Companies there off-load their pension assets by purchasing a group annuity from an insurer. That market took off 18 months ago when the country's regulators instituted more onerous pension accounting rules. Since then, nearly a dozen specialized insurers have opened up shop to offer the products. Many of the new players are backed by Goldman Sachs, JPMorgan, Cerberus, Warburg Pincus, and Deutsche Bank—some of the same names that are trying to import the concept to the U.S.

U.S. companies already have that avenue of escape thanks to the federal pension rules. But the high costs associated with such insurance products have limited their use. That's already changing. A dozen U.S. life insurers, including John Hancock, Prudential, and MetLife, now offer a way for companies to get rid of the pension burden.

And though the market remains small, insurers sold $2.88 billion worth of such policies last year—triple the amount three years ago. Those figures could rise if Wall Street decides set up insurance units to offer those types of annuities.

The US mortgage finance empire Freddie Mac yesterday predicted the worst housing slump since the Great Depression as it set aside $2.5bn (£1.28bn) to cover credit liabilities caused by delinquent loans and foreclosures.

Two weeks after the US government hastily assembled a rescue package to support the business, Freddie revealed a second-quarter loss of $821m - a big jump in comparison with its first-quarter deficit of $151m. Richard Syron, chief executive of Freddie Mac, said: "As we're all painfully aware, the housing correction has had a significant impact on the US economy." He admitted that the credit environment was deteriorating "even faster than we thought".

The government-sponsored company has a loan portfolio of more than $1.5tn. Along with its sister firm, Fannie Mae, it buys mortgages from lenders and securitises them on the financial markets in its mission to broaden access to home ownership.

Syron predicted yesterday that the American housing slump would be even deeper than anticipated. He said the company believed prices would drop by between 18% and 20% from their peak, exceeding its earlier forecast of 15%. In a statement, the company said it was "in the midst of the single largest decline in real estate values since the Great Depression".

Syron said: "Today's challenging economic environment suggests the housing market is far from stabilising. We now think we're about halfway through the peak-to-trough decline." Alarm about the financial position of Fannie and Freddie has sent shares in the two companies plummeting by more than 80% this year.

Freddie's loss, which was significantly greater than analysts had predicted, sent its stock down by 15% in early trading on Wall Street. Freddie intends to raise $5.5bn of new capital to bolster its reserves and is slashing its dividend. The company insisted that its cash remained above regulatory targets - it has $37.1bn of core capital, which is $2.7bn more than the surplus required by the US government.

Congress recently nodded through a bill allowing the US treasury to lend money or buy shares in Freddie and Fannie to keep the businesses afloat. Economists fear that a collapse of one or both could have grave repercussions throughout the financial system. Between them, they back more than half of new US mortgages.

Syron said he did not believe such drastic taxpayer support would be needed: "While we do not expect to draw on any of the new backstops going forward, they provide important sources of reassurance and potential support in the event that the housing market declines even further than anticipated."

Analysts believe investors are likely to attach stringent terms to any fundraising by the company. Walter O'Haire, of the Boston financial consultancy Celent, said: "What will be interesting to see are the terms investors will demand in return for buying into Freddie Mac's proposed $5.5bn stock offering."

The number of U.S. workers filing new claims for unemployment benefits unexpectedly rose last week to a six-year high, as the recent extension of unemployment benefits continued to draw new claimants into the system.

Still, those technical issues aside the numbers, which included another rise in continuing claims, suggest the outlook for labor markets and consumer spending remains bleak as households face high energy prices and falling home values.

Separately, a forecasting tool for sales of previously owned homes rose in June, but remains well below levels from one year ago. Initial claims for unemployment benefits rose 7,000 to 455,000 after seasonal adjustments in the week ended Aug. 2, the Labor Department said Thursday. That's the highest level since March 2002. Economists in a Dow Jones Newswires survey expected a 20,000 decline.

Claims were choppy throughout last month, due at the beginning to annual shutdowns at auto makers as they retool their plants and at the end to the extended benefits issue. Some applicants for the new 13-week extension actually found that they were eligible for new jobless benefits.

Thus, "people are coming into the system that probably would not have filed absent" the extended-benefits program, a Labor Department analyst said Thursday, though the analyst was unable to say exactly how many. The government has said this effect will lead to higher-than-expected claims for several weeks.

The four-week average -- which attempts to smooth out weekly volatility -- jumped by 26,750 to 419,500, the highest level since July 2003 and well above the 400,000 mark that's usually associated with recessions.

Nonfarm payrolls fell for a seventh-straight month in July, the government said Friday, pushing the jobless rate to a four-year high of 5.7%. Barring an unexpected reversal in weekly claims and economic conditions as a whole, payrolls will probably fall again this month.

The Labor Department report Thursday included the total number of workers drawing unemployment benefits for more than one week in the week ending July 26, the latest period for which those figures are available. The number -- known as continuing claims -- rose 31,000 to 3,311,000, the highest level since December 2003, suggesting it is taking much longer for the unemployed to find new work.

The unemployment rate for workers with unemployment insurance was unchanged at 2.5%. On an unadjusted basis, Ohio reported the largest increase in new claims the week of July 26, 4,634, due to layoffs in the automobile industry. Michigan had the biggest decrease, 7,492. It did not provide any details.

The Oakland, California, agency that runs toll bridges across the San Francisco Bay is proving that the era of cheap money for municipal borrowers is over.

This week the Bay Area Toll Authority sold more than $700 million of bonds at rates as high as 5.34 percent to refinance debt that cost 4 percent last year. That leaves less money to finance projects, such as bridge improvements. "The cost of money just went way up," said Brian Mayhew, the agency's chief financial officer. "You may have projects on the cusp that are going to be difficult to do."

Almost a year after the Federal Reserve began to cut its target rate for overnight loans between banks to 2 percent from 5.25 percent, borrowing costs for states, cities, hospitals and municipal authorities are going in the opposite direction.

The $2.66 trillion municipal debt market is reeling from a series of jolts springing from a decline in the creditworthiness of insurers that once backed half of all securities sold at the same time the economy teeters on the edge of a recession, eroding tax revenue. Bond prices have fallen an annualized 4.75 percent so far this year, the most since tumbling 11.3 percent in 1999, Merrill Lynch & Co.'s Municipal Master Index shows.

"The world is falling apart" for borrowers, said Robert Doty, the president of American Governmental Financial Services, an advisory firm in Sacramento.

Top-rated tax-exempt bonds due in 10 years have yielded an average of about 99 percent of Treasuries with similar maturities this year, and reached a record of 115 percent in February, according to Concord, Massachusetts-based research firm Municipal Market Advisors.

Because of their tax benefits, municipal debt typically yields about 87 percent of Treasuries. Spread over the $330 billion of fixed-rate municipal debt that JPMorgan Chase & Co. estimates will be sold this year, that translates to as much as $1.6 billion in extra interest costs annually over the historical average.

"The unwinding of the credit bubble has had dramatic implications," George Friedlander, a municipal strategist at Citigroup Inc. in New York who has covered the market for more than 30 years, said in an Aug. 1 report. Washington D.C.'s interest costs on some floating-rate bonds rose to as high as 15 percent this year, adding $4 million to its debt expense, said Lasana Mack, deputy chief financial officer.

"We recognized that some unprecedented things had occurred in the market, but of course it doesn't feel good to pay 15 percent," Mack said. The district converted about $800 million of auction-rate securities and other floating-rate bonds into variable debt with stronger backing from banks, and plans to convert another $125 million.

The College of Santa Fe in New Mexico is stuck with debt that's threatening to consume a larger share of its $27 million budget. The rate on a $25 million bond sold by the college is now at 10 percent, more than double a year ago.

The college has been unable to persuade a bank to put up a letter of credit that would guarantee the bonds from default and help lower rates, said David Rivard, the school's vice president of finance. "Nothing has stabilized, and rates have just been going up," Rivard said.

That's not what Fed Chairman Ben S. Bernanke had in mind when he starting slashing the Fed's target rate in September as the credit market seized up. Instead, the economy continued to worsen, eroding tax revenue. During the first three months of 2008, tax revenue climbed at the slowest pace since 2003 as sales-tax collections fell for the first time in six years, according to the Nelson A. Rockefeller Institute of Government in Albany, New York.

The National Conference of State Legislatures in Washington described the plight of municipal finances in a July report. The state lawmakers group found that states are cutting spending on schools and health care, tapping reserves and borrowing to close $40 billion of budget gaps. New York, Virginia and eight other states trimmed spending across the board for the budget year that began in July for all but four states. Seven of the 31 states with fiscal 2009 deficits raised taxes.

When the rate on bonds issued by San Francisco International Airport and insured by Syncora Guarantee Inc., formerly XL Capital Assurance, and Financial Guaranty Insurance Co., both of New York, rose as high as 9 percent this year, airport officials decided to convert the debt to new securities guaranteed by insurers that hadn't lost their AAA ratings.

The benefits proved temporary. Moody's Investors Service on July 21 said that the ratings for those companies, New York- based Financial Security Assurance Inc. and Assured Guaranty Ltd. in Bermuda, may be reduced as well. The airport's borrowing costs jumped by about a percentage point, said Kevin Kone, who handles the airport's finances.

"This is the same cycle and profile and story the other guys went through before they lost their rating," Kone said of the insurers, adding that the airport may need to refinance again if the companies are stripped of their AAA ratings. "When this started happening last August, people thought the sky was falling and, knock on wood, we were able to get through it and repair all our debt.

Maybe this time it may be more difficult because if you have no bond insurance, what's the market going to do?"

Defaults on bonds may rise to as much as 10 percent worldwide within a year as economic growth slows, according to Moody's Investors Service.

While defaults on high-yield, high-risk bonds are likely to reach 6.3 percent in 12 months, the rate may be higher should the housing slump lead to a "protracted U.S. recession," the New York-based rating company said in a report today. The default rate increased to 2.5 percent in July, from a revised 2.1 percent the month before, the biggest jump since November.

"The global default rate will climb sharply over the next 12 months," Kenneth Emery, director of default research, said in the report. "The pace of corporate defaults increased considerably in July as economic conditions weakened and more companies experienced financial distress."

A year after losses on U.S. subprime mortgages caused credit markets to seize up, higher borrowing costs and slumping consumer confidence are increasing the pressure on debt-laden companies. Banks around the world have posted more than $490 billion in losses and writedowns since the start of the crisis last year, making them less willing to lend.

Defaults in the U.S. may climb to 5.7 percent by year-end and to 7.2 percent in 12 months, Moody's said. The rate rose "noticeably" to 3 percent in July, from 2.5 percent a month earlier. The rate in Europe is forecast to increase to 2.5 percent by the end of this year, after staying unchanged at 0.7 percent in July.

Of the companies rated by Moody's, 11 defaulted globally in July, the most in five years. They included nine companies in the U.S., French vodka maker Belvedere SA and Ainsworth Lumber Co. Ltd., the unprofitable Vancouver-based forest products company.

So far this year, 48 companies have defaulted, compared with 12 in the same period a year ago, Moody's said.Airlines in the U.S. are the most vulnerable, Moody's said. In Europe, the "most troubled" companies will be producers of durable consumer goods, according to the report.

The chance of General Motors Corp. defaulting is more than 80 percent and for Ford Motor Co. the risk is about 75 percent, according to an analysis by UniCredit SpA based on the cost of five-year credit-default swaps. Combined with Chrysler LLC, the likelihood that one of the top three U.S. automakers will be unable to fund its business is more than 95 percent, the analysts said.

Six companies defaulted on leveraged loans in July, all of which were in the U.S., Moody's said. The default rate on loans was 2.8 percent, up from 0.3 percent a year ago, Moody's said. High-yield, high-risk or leveraged debt is rated lower than Baa3 by Moody's and BBB- by Standard & Poor's.

In November, the worldwide default rate fell to as low as 0.9 percent, according to the report. Defaults were running at 1.5 percent a year ago.

How much is mortgage-finance giant Freddie Mac worth? Judging by the stock market, $4.2 billion, its market capitalization at the close of trading on Aug. 6. But the company's update on its second-quarter earnings and financial condition, released Aug. 6, seems to tell a grimmer story.

Look past the devastating $821 million loss it reported for the quarter—nearly three times what Wall Street analysts had forecast. Ignore the $1 billion writedown the government-sponsored enterprise took on subprime and other risky mortgages, only the latest in a painful series. Disregard the rising rate of foreclosures, which grew 20% in the June quarter from the preceding quarter.

Drill down to its fair value—a measure of the total worth of the assets on its balance sheet, minus its total liabilities. What do you see? It looks an awful lot like a gaping hole. Freddie's fair value as of June 30 was a negative $5.6 billion. Based on this particular measure of its financial condition, if it had to sell its assets today, Freddie Mac would be worth less than nothing.

Freddie says that number is wrong. And to give the GSE its due, it most likely is. Fair value is a mark-to-market number, a theoretical figure at best and as much a result of investor sentiment as the actual quality of the assets. Freddie is required to mark some assets down now, and CEO Richard Syron expects to write them back up in the future.

In fact, Freddie looks much stronger on a cash basis, sitting on $37.1 billion in capital at the end of the second quarter, $2.7 billion more than its mandatory capital surplus. Analysts disagree, however, about just how much stronger. Freddie's capital position is not a panacea. "It doesn't make me feel much better," says Chris Whalen of Institutional Risk Analytics. He calls the negative fair-value figure "a grotesque number."

Of course, Freddie isn't going away anytime soon. In July, Congress approved legislation to provide emergency financing to the company and allow the U.S. Treasury to buy Freddie's stock. Syron, however, says he will do everything to avoid tapping the government's emergency kitty.

To shore up its balance sheet, Freddie cut its dividend from 25¢ to 5¢ a share, a move that CreditSights analyst Richard Hofmann estimates could save the company $518 million annually. Freddie also plans to raise $5.5 billion in capital by selling common and preferred stock.

Yet investors who bought preferred shares back in November can't be happy with the way the investment has worked out, now that Freddie's common stock is trading at 6.49 instead of the 25 it fetched at the time of the sale. If market players avoid the preferred offering, Freddie may be forced to raise the entire amount with common stock, a move that would cut shareholder equity per share by more than half.

Even then, a common offering might not be entirely successful. Freddie's "expected capital raise may meet market resistance," credit rating agency Fitch said in a note. And if the housing market continues to deteriorate, $5.5 billion may not be enough. Freddie says it can withstand up to $40 billion in losses before it falls below its mandated capital levels.

Yet by its estimates, home prices are only halfway through their expected decline and could drop another 10 percentage points before bottoming, a total haircut of 20%. In the face of that kind of hit, Freddie may be hard-pressed to maintain its capital limits and be forced to raise more cash, most likely by selling the government preferred shares.

"If the private sector doesn't want to provide [financing]," says Dan Seiver, a finance professor at San Diego State University, "the U.S. Treasury will." Estimates vary on how much money Freddie will need to raise. Friedman Billings Ramsey analyst Paul Miller puts the number at $10 billion. Bill Gross, who manages PIMCO's Total Return bond fund, told Bloomberg Television the amount could be closer to $30 billion.

And Institutional Risk's Whalen? "If they raised $100 billion, maybe I'd take a look," he says.

Freddie Mac can meet capital standards for now, but it faces a "significant" possibility of falling below those levels because of the deteriorating housing sector.

The government-sponsored mortgage finance company said Wednesday that it expects housing prices to fall a total of 18% to 20% from their height, which is worse than its previous 15% forecast. Regulatory capital standards are sensitive to shifts in things like housing prices.

Falling below the threshold "would lead the company to be classified as undercapitalized," Freddie said in its quarterly financial filing on Wednesday. "The sharp decline in the housing market and volatility in financial markets continue to adversely affect our capital," Freddie said in the filing, "including our ability to manage to our regulatory capital requirements and the 20% mandatory target capital surplus."

The filing came on the same day that the company reported worse than expected losses, and its shares fell 19%. Even borrowers with good credit are falling behind, especially in California, Florida, Nevada and Arizona, Freddie said. This echoed what was said last month when big banking companies like JPMorgan Chase reported. Freddie lost $821 million in the second quarter, or $1.63 a share. Analysts expected it to lose 53 cents a share.

The fragile state of the mortgage finance sector led federal regulators to toss a lifeline last week to Freddie and Fannie Mae, its bigger sister. The two companies hold or guarantee half of U.S. mortgage debt. The U.S. Treasury Department has temporary authority from Congress to make loans and inject equity into the two companies to keep them viable, and the Federal Reserve made its emergency lending window available to them.

The Securities and Exchange Commission also stepped in and issued an emergency order, set to expire next week, to restrict short sales of Fannie and Freddie stock, along with shares of 17 major Wall Street banks. The Treasury said Wednesday it has hired Morgan Stanley to advise it as the department studies ways to tighten oversight of the two companies.

Morgan Stanley will analyze Fannie and Freddie's finances and capital structures. The Treasury, run by former Wall Street titan Henry Paulson, acknowledged in a statement Wednesday that it was unusual for it to turn to an advisor for help, but these are unusual times.

"We have no plans to utilize the temporary authorities," a Treasury statement said, referring to the lending powers enacted by Congress. "This action should be interpreted as a prudent preparedness measure and nothing more." Morgan Stanley won't be able to underwrite securitizations for Fannie and Freddie until January, when its deal with Treasury is over. Last year it was the sixth biggest underwriter, though it has fallen to No. 13 so far this year.

Freddie is shoring up in the face of the housing headwinds. It is cutting its dividend to 5 cents or less, from 25 cents, and it still plans to sell $5.5 billion in stock, though on Wednesday it said it won't do that until the markets calm down. "There's no need for us to rush," Freddie's chief financial officer Buddy Piszel said on a conference call.

Capital of $37.1 billion was $8.4 billion above minimum requirements and $2.7 billion above the 20% surplus target its regulator requires. Given the deteriorating housing markets, and its own grimmer view of the situation, Freddie will likely take additional steps to keep above the thresholds. It said in its regulatory filing it could slow purchases for its credit guarantee portfolio or limit or reduce the size of its mortgage bond holdings. Goldman Sachs and JPMorgan are advising it.

There’s been a lot of talk of the government’s “bailout” of Fannie Mae and Freddie Mac, but the recent legislation just authorized Treasury intervention if necessary. So far, the only government money spent is a $94,000 fee to Morgan Stanley for advice.

However, Freddie Mac’s announcement today of a much-larger-than-expected $821 million loss raises the question of whether a bailout is inevitable. For its part, Freddie officials maintain that they are adequately capitalized. “We’re managing the firm to not have to access the government support,” Chief Financial Officer Buddy Piszel told the AP.

And Treasury Secretary Henry Paulson made it clear in congressional testimony last month that the plan to extend credit to Fannie and Freddie or purchase equity in the government-sponsored enterprise is a “backup facility, [that] hopefully would never be used.” Today officials at Freddie Mac reiterated the intent to raise $5.5 billion in capital, and possibly more, but said they are waiting for market conditions to improve.

Some analysts say they don’t have time to wait. Freddie Mac “needs to raise capital today, not wait and hope for a chance to raise cheaper capital in the future,” said Friedman, Billings, Ramsey & Co. in a research report. “We continue to estimate that [Freddie Mac] needs to raise $10 billion to $15 billion.”

Meanwhile, losses continue to mount, particularly in Alt-A loans. Fannie and Freddie bought or guaranteed large amounts of such loans in 2006 and 2007, as conditions in the housing market were beginning to seriously deteriorate. Freddie Mac said in a conference call that it can handle $40 billion in credit losses through next year and still manage with the planned $5.5 billion addition in equity.

While $40 billion in losses is at the high end of analysts’ estimates, it is certainly within the realm of possibility. “Either investors are going to be massively diluted given the amount of equity they are going to need or they are going to be nationalized,” Dan Alpert, managing director of Westwood Capital LLC in New York, told Reuters. “Without a larger equity capital base, they are going to be incapable of surviving. We don’t think $5.5 billion even scratches the surface.”

Bill Gross, who manages the world's biggest bond fund, said the U.S. Treasury will probably be forced to buy as much as $30 billion of preferred shares in both Fannie Mae and Freddie Mac to help shore up their capital.

"By the end of the third quarter, the preferred stock in Fannie and Freddie will be issued, the Treasury will have bought it," Gross, co-chief investment officer at Pacific Investment Management Co., said today in an interview on Bloomberg Television. "We'll be on our way toward a joint Treasury-agency combination."

Gross adds to a growing chorus of investors and analysts predicting U.S. Treasury Secretary Henry Paulson will need to use his newly won power to prop up Freddie and Fannie. Freddie posted a second-quarter loss that was three times wider than analysts estimated and said credit losses doubled in three months, heightening concerns it may not be able to weather the worst housing slump since the Great Depression.

Freddie Chief Executive Officer Richard Syron today told investors the company will wait for its stock to improve before starting its planned $5.5 billion capital raising. Freddie agreed in May to raise the capital but failed to complete a sale as its stock slumped as much as 80 percent.

"I have enormous respect for Bill Gross," Syron, 64, said today in an interview with CNBC. "I think he's an extraordinarily talented manager, particularly on the fixed income side. But based on the information I have now, I do not believe that the Treasury will end up having to inject money into Freddie Mac."

Gross is among investors and analysts predicting that won't be enough. The government will probably buy $10 billion to $30 billion of preferred stock, Gross said. "If they're unable to tap the markets to raise capital, we're talking a matter of quarters before the government has to step in," said Joshua Rosner, an analyst with independent research firm Graham Fisher & Co. in New York.

Freddie needs to raise at least $10 billion immediately, according to Paul Miller, an analyst at Friedman Billings Ramsey & Co., who rates the stock "underperform." The company's reluctance to raise more capital will hurt its recovery and increase the odds it will need federal aid. "The company is defiant that all they are going to need is $5.5 billion in capital, and the Street is not going to accept that," Miller said. "Are they waiting for better times? It's just going to get worse over the next six months."

Freddie said today its capital is $2.7 billion above the mandatory target surplus set by its regulator, down from $6 billion. The fair market value of its assets, a measure of insolvency, declined to a negative $5.6 billion.

"This report significantly shortens the timeline for Treasury intervention," said Ajay Rajadhyaksha, the head of fixed-income research for Barclays Capital in New York. With the value of Freddie's outstanding stock now at $4.3 billion, Rajadhyaksha said, "I don't see how they can raise capital by themselves without a capital infusion from Treasury."

About 61 percent of the holdings of Gross's Pimco Total Return Fund were mortgage-backed securities as of June 30, mostly debt guaranteed by Fannie, Freddie or U.S. agency Ginnie Mae, according to data on Pimco's Web site.

The fund has returned 5.5 percent annually over the past five years, beating 86 percent of its peers in the government and corporate bond fund category as of Aug. 5, according to Bloomberg data. Pimco, a unit of Munich-based Allianz SE, has $830 billion of assets under management.

After years of being criticized for their lobbying might, Fannie Mae and Freddie Mac are now defending their right to lobby at all.

Some lawmakers argue that the mortgage lenders should not be allowed to lobby the federal government because taxpayers could be on the hook for billions of dollars if the Treasury has to bail them out. Fannie Mae and Freddie Mac have rejected the argument and, so far, have shown scant signs that they plan to temper their activities.

"We have every right to defend ourselves and advocate for our positions, particularly since we play such a critical role in housing finance," Freddie Mac spokesman Douglas Duvall said. As part of a housing rescue package made law last week, the Treasury has temporary authority to buy stock in the companies and lend to them, if needed.

Sen. Jim DeMint (R., S.C.) is preparing legislation that would bar the companies from lobbying and making political donations if the Treasury uses taxpayer funds to bail them out. Although such a bill could run afoul of the Constitution, Senate Majority Leader Harry Reid has said he had "no problem" with the intent, and he predicted it could attract bipartisan support.

A lobbyist for Fannie attended a July 30 breakfast for Sen. Reid (D., Nev.), where guests were asked to donate either $2,500 from their company's political-action committee or $1,000 of their own money to the senator's campaign fund. This week, the top lobbyist for Fannie Mae, Duane Duncan, and a Freddie Mac lobbyist, David Lynch, went to Columbus, Ohio, for a golf outing for House Minority Leader John Boehner (R., Ohio).

Attendees were asked to donate either $5,000 from their company's PAC or $2,000 of their own funds to Rep. Boehner's leadership PAC. The lobbyists attended the events shortly after Fannie and Freddie said they would not attend the Democratic and Republican conventions, where they had planned to co-host receptions.

Amy Bonitatibus, a Fannie Mae spokeswoman, said it was important for the company "to communicate our views and concerns in order to advance homeownership and affordable housing in America." The companies' defenders argue that Sen. DeMint is unfairly singling out the mortgage lenders when many investment banks have benefited from the federal government's intervention during the credit crunch.

"All Sen. DeMint is asking is for Fannie and Freddie to play by the same rules as other federal entities," said a DeMint spokesman, Wesley Denton. Fannie Mae and Freddie Mac have long stirred controversy for the huge sums they have spent to gain influence. Together, they have spent more than $170 million on lobbying in the past decade, according to the Center for Responsive Politics.

Although their spending has diminished in recent years in the wake of lobbying scandals at the two companies, it is still significant. Fannie Mae spent $5.6 million on lobbying last year, while Freddie Mac spent $8.5 million. Both are poised to lobby hard over the next few years, shifting efforts to regulators from Congress in hope of fending off onerous regulation, company lobbyists said.

Fannie and Freddie have attracted one unlikely ally: Mike House, former executive director of FM Policy Focus, a coalition of competitors to Fannie and Freddie that had lobbied for years for tougher scrutiny of the companies and that was just disbanded. "As long as they have shareholders and they're publicly traded companies, they should have a right to representation," he said.

Citigroup Inc. may be forced to buy back about $8 billion in auction-rate securities and fined as much as $100 million in a settlement with U.S. regulators over claims it improperly saddled retail customers with untradeable bonds, two people familiar with the case said.

Citigroup, the biggest underwriter of such debt, is in talks with the Securities and Exchange Commission, New York State Attorney General Andrew Cuomo and a group of all the other states, led by Texas, the people said. A preliminary agreement may be reached as early as this week.

The settlement may set a precedent for negotiations with firms including UBS AG, which has already been named in civil complaints by Cuomo and authorities in Massachusetts. Other firms that sold the securities are also nearing the completion of talks to resolve regulatory probes, one of the people said.

"What we're seeing here is just the tip of the iceberg," said Jill Fisch, a law professor at the University of Pennsylvania. "From Citigroup's perspective, it's good to try to get this resolved instead of it being drawn out through litigation."

The settlement would be another blow to Citigroup Chief Executive Officer Vikram Pandit, 51, who recorded a $2.5 billion loss in the second quarter because of $12 billion of writedowns and increased bad-loan reserves. The regulators are coordinating efforts to make sure individual investors, charities and small businesses regain access to funds quickly, while the states also press for the additional fine, one of the people said.

Citigroup spokeswoman Susan Thomson and SEC spokesman John Nester declined to comment on the proposed buyback. The Wall Street Journal reported the settlement talks between Cuomo and Citigroup earlier today. The regulators may also require the bank take steps to ensure that other clients, such as institutional investors, are able to exit an additional $12 billion in auction-rate instruments in the coming months, another person briefed on the talks said.

The SEC may postpone a decision on whether to seek its own penalty until it can gauge the bank's efforts. UBS, the biggest Swiss bank, was in talks today with Massachusetts, Texas, New York and the SEC, said a person familiar with those negotiations. Asked about the talks, UBS spokeswoman Karina Byrne said, "We have consistently worked with and are engaged in active dialogue with all our regulators."

Auction-rate securities are typically bonds whose interest rates are reset by periodic bidding. Firms including Citigroup abandoned their routine role as buyers of last resort for the instruments in mid-February, allowing the $330 billion market to collapse.

A settlement with the SEC would still require approval by the Washington-based agency's commissioners. The regulator is considering how reversing auction-rate sales may affect banks' stability amid the global credit crisis, one of the people familiar with the case said. "The SEC will take into consideration what is good for the country overall," said Tamar Frankel, a law professor at Boston University. "The purpose is to stop the bleeding and stop the unraveling of our financial system."

The market's seizure left Citigroup holding at least $6.5 billion of auction-rate securities on its trading desk at the end of March, after booking $1.5 billion of writedowns during the first quarter, according to a May regulatory filing from the bank. In the second quarter, the bank whittled the inventory to $5.6 billion and booked $197 million of gains as "some liquidity returned to the market with a number of auctions being completed," it said in a filing last week.

The bank helped retail clients reduce their holdings in auction-rate securities by about half since February, a person familiar with the situation said. About 24 percent of the remainder are instruments whose auctions resumed by June 30. Similar settlements may follow, said Barry Silbert, chief executive officer of New York-based Restricted Stock Partners, which operates a secondary market for hard-to-trade securities.

A Citigroup buyback "could force the hand of other banks to do something similar," Silbert said. Whether Citigroup loses money on such purchases depends on whether it then sells the securities for less than it paid investors. Their current prices vary from as high as 98 cents on the dollar for auction-rate bonds sold by local governments to less than 50 cents for securities sold in collateralized debt obligations, which were widely bought by corporate treasurers, Silbert said.

Citigroup might not lose any money on its purchases of local government auction-rate debt, because governments and municipalities have been repaying them at 100 cents on the dollar with proceeds from new bond sales. Governments, schools and hospitals have replaced or announced plans to replace about 58 percent of the $166 billion of auction-rate securities they had outstanding in February, data compiled by Bloomberg show.

Cuomo accused Citigroup of fraud in an Aug. 1 letter, claiming the firm should have told clients the auction-rate market survived between August 2007 and February 2008 only because of bidding from the bank. The letter demanded Citigroup buy back investors' holdings in the "immediate future," reimburse their damages and pay a "significant" fine.

The bank said that same day it was working with regulators and market participants to find an "industrywide solution" to auction-rate securities issues. It has been cooperating with regulators, including Cuomo, to ensure liquidity for clients. "We're obviously working as hard as we can and we hope it will reach a resolution real soon in order to get investors their money back," said Benette Zivley, director of the Texas State Securities Board's inspection and compliance division.

Ilargi: I'm trying to think of a precedent of large scale fraud in which the defendant (mind you, Citi has admitted nothing) has paid, what Cuomo called a "significant fine"(?!), of 1.25% of the amount involved.

Citigroup Inc., the largest U.S. bank by assets, agreed to buy back or help clients unload $19.5 billion in auction-rate securities and pay a $100 million fine to settle U.S. regulatory claims it improperly saddled customers with untradeable bonds.

Citigroup will buy back about $7.5 billion in securities from individual customers, charities and small businesses under a settlement with New York State Attorney General Andrew Cuomo, the Securities and Exchange Commission and a group of states, led by Texas, the SEC said in a statement today. It must also start "restoring liquidity" to more than 2,600 institutions holding about $12 billion of the instruments, the SEC said.

Citigroup is the first Wall Street firm to settle federal claims amid a probe into how banks sold auction-rate securities before the $330 billion market collapsed in February. The accord may set a precedent for negotiations with firms including UBS AG, which has been named in civil complaints by Cuomo and authorities in Massachusetts.

"Firms that don't settle are going to be frowned upon by investors," Texas State Securities Commissioner Denise Voigt Crawford said.Citigroup agree to buy back illiquid securities from about 40,000 customers by Nov. 5 and compensate clients who already sold their holdings at a loss, according to Cuomo.

The accord also requires that the New York-based bank make "best efforts" to help 2,600 institutions by the end of 2009, the SEC said. Cuomo reserved the right to take legal action, and the SEC may seek a fine, if the bank doesn't do enough for those investors. The company also agreed to reimburse refinancing fees to municipal borrowers that issued auction-rate securities through Citigroup since Aug. 1, 2007, according to a statement released by the New York attorney general.

Citigroup neither admitted nor denied allegations of wrongdoing. "We are committed to continuing the many initiatives that we believe will provide liquidity to our auction-rate clients," said Arthur Tildesley, chief administrative officer for Citigroup's wealth-management division.

Citigroup estimated that securities eligible for the buyback have a face value of $7.3 billion and may be worth about $500 million less on the market than their purchase price. Under accounting rules, Citigroup may have to record a pre-tax loss to reflect the difference. The actual loss "will depend on the market value at that time and the amount of securities purchased," the bank said in the statement.

The capital impact on its balance sheet will be "de minimis," it said. The accord is another blow to Citigroup Chief Executive Officer Vikram Pandit, 51, who recorded a $2.5 billion loss in the second quarter because of $12 billion of writedowns and increased bad-loan reserves.

"This is very unusual," said J. Boyd Page, an attorney at Page Perry LLC in Atlanta specializing in securities fraud. "Anything of this magnitude is unprecedented."

American International Group Inc. (AIG) swung to a second-quarter loss on more than $11 billion in investment losses and a write-down related to its credit default swap portfolio. Shares fell 7.5% in after-hours trading as the insurance giant posted its third consecutive quarterly loss.

Steep write-downs tied to subprime mortgages resulted in AIG posting a total of $13 billion in losses in the previous two quarters. The latest quarter included $6.08 billion in pre-tax net realized capital losses and a $5.56 billion pre-tax write-down related to its credit default swap portfolio.

"Our second-quarter results were adversely affected by the severe conditions in the housing and credit markets and a very difficult investment environment. These results do not reflect the earnings power and potential of AIG's businesses and it is clear that we have a lot of work to do to restore AIG's profitability to where it should be," said Chief Executive Robert Willumstad.

He had replaced Martin Sullivan, who resigned in June amid pressure from major shareholders to improve the company's performance. In the second quarter, the insurance giant reported a net loss of $5.36 billion, or $2.06 a share, compared with net income of $4.28 billion, or $1.64 a share, a year earlier.

AIG had an operating loss, which excludes investment gains or losses and other items, of 51 cents a share compared with operating earnings of $1.77 a year earlier. Revenue dropped 36% to $19.9 billion. Analysts' mean estimates were for per-share operating earnings of 63 cents on revenue of $31.49 billion, according to a poll by Thomson Reuters.

Earnings in AIG's general-insurance segment fell 72% on lower investment income and bigger losses at United Guaranty Corp., which writes mortgage insurance. Net premiums written increased 0.7%, and all lines grew except commercial, mostly because of declines in workers compensation. The combined ratio, a ratio of benefits paid to premiums earned and a key indicator of an insurance company's profitability, rose to 97.71% from 87.12%. A figure below 100% indicates an underwriting profit.

The life insurance and retirement services business posted an operating loss of $2.4 billion compared with earnings of $2.62 billion a year earlier, while the financial-services segment had an operating loss of $5.9 billion compared with year-earlier earnings of $47 million.

The asset-management business reported an operating loss of $314 million compared with a year-earlier profit of $927 million.After becoming chief executive, Willumstad, who had been AIG's chairman since 2006, launched a review of the company's businesses, which range from car and life insurance to consumer lending to aircraft leasing. He said Wednesday that he would report on his findings in late September.

Many people have speculated that AIG may sell or spin off some units, especially noninsurance businesses. However, Willumstad recently said aircraft- leasing titan International Lease Finance Corp. will remain a part of AIG. In May, AIG raised $20.25 billion by selling common stock, equity units and fixed-income securities, 62% more than its original target because of strong demand.

AIG has been more exposed to the mortgage market than many insurers; it sells mortgage insurance and makes consumer loans, and it sold credit protection on mortgage-backed securities. AIG's shares were recently trading down $2.18, or 7.5%, to $26.91 in after- hours trading. The stock price has fallen 61% since last fall.

A group of Wall Street executives released a report on Wednesday that outlined how the industry failed to foresee the financial meltdown of the last year and what companies can do to improve risk management.

The 172-page report, written by chief risk officers and senior executives at banks like Lehman Brothers, Merrill Lynch and Citigroup, also provides suggestions about technical issues at the same time as it offers a bit of a mea culpa.

“Virtually everybody was frankly slow in recognizing that we were on the cusp of a really draconian crisis,” said E. Gerald Corrigan, a managing director at Goldman Sachs and a chairman of the Counterparty Risk Management Policy Group III , which released the report.

Wall Street failed to anticipate how wide-reaching problems with mortgage bonds would spread into seemingly distant corners of the financial markets, the report said. Awash in easy money, banks doled out credit without sufficiently charging for the risk.

Wall Street also created complex structures that masked connections between asset classes as well as compensation incentives that pushed traders to take risky steps for short-term gain. The industry’s failings have now translated into pain for the broader economy, the report said.

In many ways, the report acknowledged shortcomings that have already been raised by Wall Street’s critics.Mr. Corrigan, a former president of the New York Federal Reserve, formed the group in April to develop a private-sector plan for minimizing future problems in the financial markets. He said in an interview that he hoped the report’s suggestions would be adopted industrywide within two years.

The report focuses on several issues, including accounting rules for bundles of mortgages, new tests for liquidity and disclosure of risks in complicated financial instruments. The findings have already been presented to Timothy F. Geithner, the president of the New York Federal Reserve.

In a cover letter to Treasury Secretary Henry M. Paulson Jr., the group attributed some of the crisis to human psychology. “The root cause of financial market excesses on both the upside and the downside of the cycle is collective human behavior — unbridled optimism on the upside — and fear — bordering on panic — on the downside,” the letter said.

The panic underlying the collapse of the investment bank Bear Stearns was clearly on the minds of executives as they worked on the report. They outlined ways to reduce “counterparty risk,” the intricate links that connect financial companies and their trading partners.

As Bear Stearns struggled in early March, investors feared that too many of those links would collapse if the bank folded — leading some Wall Street executives to say that Bear Stearns was not too-big-to-fail but rather too-interconnected-to-fail.

The report suggests that the industry create a way to close-out trades, should another major financial player face trouble. It also said the markets may be more “accident prone” because of new ways of doing business like Wall Street’s loan packaging, in which banks that originate loans to consumers then repackage them to sell to investors.

And it listed the ability to make bets against credit — a trade that made some investors rich — as a possible cause of market instability. Mr. Corrigan said a prior version of his group created rules that helped the financial system through recent turbulence. Under those rules, investors could no longer resell derivatives contracts without the permission of the party on the other side of the trade.

Now Mr. Corrigan is pushing for the industry to establish a central clearinghouse for derivatives. The clearing project is supported by the Federal Reserve, but many Wall Street firms are concerned that such a move could open their lucrative over-the-counter trading operations to competition from exchange companies.

Another hotspot in the report is the section about accounting for bundles of mortgages and other loans that have been packaged. Those have been kept off the balance sheet, and many in the industry think that rules that would put the bundles back on the books should apply only to the future. The report suggests putting loan packages from the past — which will force many banks to raise more capital from investors.

Mr. Corrigan said he knows the report presents a challenge, but that Wall Street firms need to adopt more of a spirit of “financial statesmanship.” The publication of the report, he said, does not signal an end to the crisis.

“Since roughly March, we’ve kind of been bumping along the bottom,” he said. “That’s likely to continue for at least some period in the future.

The past year has seen the “most challenging financial crisis in the entire post-war period,” and industry experts have outstripped even regulators with their plans to improve the stability of the financial sector, the former president of the Federal Reserve Bank of New York said Wednesday.

Gerald Corrigan – now a managing director at Goldman Sachs – was speaking on the release of the latest report from the Counterparty Risk Management Policy Group he co-chairs. Though the report’s recommendations aren’t a fix for the current crisis, substantial progress has been made in understanding its causes, to prevent a recurrence, he noted. “That doesn’t mean there won’t be further write-downs,” he said, “there almost surely will be.”

This third report, the first since the financial crisis erupted last summer, tackles in particular the changes necessary to make doing business safer in the over-the-counter markets for derivatives and credit default swaps. The objectives in this third report, “The Road To Reform,” are “extremely ambitious, and they will take time,” Corrigan said.

But there should be no bureaucratic holdup for the proposals. Most of the steps recommended in the report can be implemented under the terms of the existing regulatory structure, Corrigan said. As a former president of the New York Fed, Corrigan is a firm believer in the key role the central bank should play in that oversight.

“Central banks are the only institutions of public policy that literally operate in financial markets every day of the week,” he said. “If that doesn’t give you some kind of advantage, I don’t know what does.” Corrigan isn’t an advocate of the Fed taking the preemptive measure of targeting asset prices, though, pointing out that bubbles are hard to identify in advance. “The risk of misjudgment and miscalculation is very high,” he said.

The mortgage giant, the Countrywide Financial Corporation was sued by Connecticut, which accused the company of steering customers into mortgages they could not afford, and charging excessive legal fees to borrowers in default.

Connecticut joined California, Florida and Illinois among the states that have sued Countrywide, which as recently as last year made one in six mortgage loans. Washington state has separately announced plans to fine Countrywide and possibly revoke its lending license. The Bank of America Corporation acquired Countrywide in July for $2.5 billion.

“Countrywide conned customers into loans that were clearly unaffordable and unsustainable, turning the American dream of homeownership into a nightmare,” Richard Blumenthal, Connecticut’s attorney general, said in a statement Wednesday. Connecticut is demanding that Countrywide make restitution to affected borrowers, give up improper gains, and rescind, reform or modify all mortgages that broke state laws.

It is also seeking fines of up to $100,000 per violation of state banking laws, and up to $5,000 per violation of state consumer protection laws. A Bank of America spokeswoman Shirley Norton declined to discuss the claims but said the bank was cooperating with the state. She also said Bank of America is reviewing Countrywide’s business, and is working to keep borrowers in their homes and be a leader in responsible lending.

In its complaint, the state called Countrywide’s lending practices “oppressive, unethical, immoral and unscrupulous.” Mr. Blumenthal accused Countrywide of inflating borrowers’ incomes to qualify them for loans they could not afford, and then misleading consumers about loan terms, revealing some only at the closing table.

He also accused the lender of bullying struggling borrowers into loan workouts that were “doomed to fail,” and assessing hefty legal fees that drove borrowers deeper into debt. “Countrywide was at their side — as an insolvency enabler,” Mr. Blumenthal said.

Other states have accused Countrywide and its longtime chief executive, Angelo R. Mozilo, of unfair, deceptive or predatory lending, including the steering of customers into subprime and other home loans they couldn’t afford. The lender, which had been based in Calabasas, Calif., made one in six mortgage loans as recently as last year, according to the newsletter Inside Mortgage Finance.

Bank of America, based in Charlotte, N.C., last month said it expected the Countrywide acquisition to add to profit in 2008, sooner than expected. But analysts have said the bank might face $10 billion or more of future losses or write-downs tied to deteriorating credit, as well as hefty legal bills tied to Countrywide.

British families could find themselves subsidising households in France after the French Government ordered a 2 per cent cap on electricity price increases yesterday.

EDF, which supplies homes on both sides of the Channel, raised its prices to British customers by 22 per cent only two weeks ago. It also put up its charges for gas by 17 per cent - but it will not be allowed to increase French prices by more than 5 per cent.

MPs said that the cap in France, where the law restricts energy price rises to the inflation rate, raised fresh questions about the lack of controls over Britain’s liberalised energy market, which were highlighted in a parliamentary report last month. EDF, whose talks about acquiring Britain’s nuclear generator British Energy came close to collapse last week, blamed its latest increase in Britain on soaring wholesale gas prices.

According to Energywatch, EDF’s latest increase took the price of its average electricity bill to £441 for direct debit customers. That is more than 11 per cent higher than the €500 (£396) that EDF said was the average for its electricity bills in France.

Steve Webb, the Liberal Democrat energy spokesman, said: “EDF will have to make up the shortfall somehow. They may have to look to customers in countries where the markets are less interventionist, like Britain.” He added that the French announcement drew a stark contrast with what he saw as fundamental flaws in the British market that failed to protect consumers.

“Energy prices are not like the price of baked beans,” he said. “It matters if people cannot afford to pay, so leaving it all to the market is just not acceptable.”

The Bank of England rebuffed mounting concerns over the rapidly weakening economy today and held interest rates at 5 per cent as it pursued its drive to quell soaring inflation.

The tough verdict from the Bank's rate-setting Monetary Policy Committee (MPC) brushed aside pleas from business leaders and trade unions for a cut in base rates to shore up Britain's growth, amid growing fears that the country is on the brink of recession.

The Bank's decision came after headline consumer price inflation leapt to a 10-year high of 3.8 per cent in June, well above the Bank's 2 per cent target, and amid expectations that it could hit 5 per cent over the summer, following swingeing increases in household gas and electricity bills imposed by utility companies.

The MPC had been widely expected to spurn pressure for a rate cut today in a bid to make clear its determination to bring inflation back to the target set by the Chancellor. The committee will almost certainly have discussed raising rates this morning, as it did last month, when Professor Tim Besley, voted for an immediate increase. He is expected to have done so again today, and may have been joined by other hawkish MPC members.

The Bank will set out its thinking more clearly next week when it publishes its latest forecasts for the economy in its quarterly Inflation Report. That is expected to emphasise the dilemma that the MPC confronts, with inflation set to soar far above target in the next few months, even as the economy slides towards a severe downturn.

Barclays takes another $2 billion credit crunch hitBarclays today apologised for its share price performance as it posted a sharp drop in profits and wrote off another billion pounds as the credit crunch continued to pummel Britain's banks.

Britain's third largest bank made pre-tax profits of £2.75bn in the first half of the year - slightly more than analysts had predicted but 33% lower than a year ago when it made £4.1bn. The fall in profits, which chief executive John Varley admitted was "acutely disappointing", was largely caused by the ongoing credit crunch, which sent profits at its Barclays Capital division tumbling by more than two thirds to £524m.

The bank said Barclays Capital had suffered losses of almost £2bn through its exposure to the credit market, including securities backed by US sub-prime mortgages. Varley said conditions in the banking sector over the past year had been "as difficult as we have experienced in many years".

"Although I take some comfort from our relative performance in managing our risks and in generating income, a decline in profit of 33% is acutely disappointing. And I add to that my disappointment at the decline in our share price. Our shareholders have had to endure a lot," he said, adding the bank was trying to work hard to improve conditions to bolster the share price.

Bob Diamond, Barclays president and head of the investment banking arm which has caused fresh £1bn of credit crunch writedowns, said the bank's management were "up for the challenge" of boosting its performance. Barclays' shares have fallen by 45% this year, but after dropping in early trading today they were up more than 4% at 11am at 385.25p, a gain of 16p.

The bank is concerned about the economies of the UK, Spain and South Africa and Varley predicted little improvement in general trading conditions for the "foreseeable future". The fresh £1bn of credit crunch writedowns comes on top of £1bn written off in the first quarter. However, if £850m of gains on the value of its own debt which the bank has offset against these losses are factored in, the writedown reaches £2.8bn for the first half.

Its total impairment charges came to £2.45bn, up from £959m. As well as Barclays Capital's charges, this included a rise in bad debts from business customers and in the UK mortgage market. The bank had been criticised for not marking down its assets as much as rivals but Barclays insists its assets are of higher quality.

In a conference call today, Varley said there had been "a great deal of disclosure" in today's results statement and he was "completely confident about the rigorous approach" of markdowns. These latest writedowns come less than a month after Barclays' £4.5bn fundraising drive from investors such as the Qatar Investment Authority.

That £4.5bn of fresh capital helped improve its crucial tier one core ratio - used to measure capital strength - which rose to 6.3%. The bank's target is for a 5.25% – it stood at 5% at the end of June before the funds arrived. Looking forward, Diamond said there would more "challenging environments" for the balance of 2008 and 2009.

However, he said the issue of liquidity was no longer a problem following co-ordinated action by central banks to inject money into the markets. "That has been by and large resolved," he said, adding that the concerns now were oil prices and how much the global economy would weaken as markets waited for an end to the freefall in the US housing sector.

Varley said the difficult trading conditions also created new opportunities for Barclays to expand its market share and diversify its business which would help the bank weather the downturn.

A year after losses on U.S. subprime mortgages caused a seizure in credit markets worldwide, European companies are starting to default.

As many as 6 percent to 7 percent of corporate borrowers may fail to pay debts on time in the next year, a 10-fold increase from July, according to Dresdner Kleinwort, a unit of Germany's third-biggest bank. That would be the highest since July 2003, according to data compiled by Moody's Investors Service, straining an already faltering economy.

"Companies that would have refinanced a year ago find now that they can't," said Andy Stoneman, managing partner at MCR Corporate Restructuring in London, the administrator for General Trading Co., the store where Prince Charles and Princess Diana had their wedding list.

Tighter credit and rising fuel and commodity prices led to Europe's biggest bankruptcy in five years last month when Spanish developer Martinsa-Fadesa SA defaulted on 5.2 billion euros ($8.1 billion) of debt. French vodka maker Belvedere SA sought protection from creditors last month. The number of U.K. companies facing a "critical" funding shortage jumped eightfold in the past year, according to restructuring adviser Begbies Traynor Group Plc.

Defaults on high-yield bonds may rise to as much as 10 percent worldwide within a year as economic growth slows, Moody's said in a report today. The rate in Europe is forecast to rise to 2.5 percent by the end of this year as banks become less willing to lend, after remaining unchanged at 0.7 percent in July.

Borrowers that can get capital are paying near-record costs. Yields on high-yield, high-risk bonds sold by European companies rose to 12.72 percent, from 8.1 percent a year ago, according to Merrill Lynch & Co. index data. That compares with 11.53 percent for U.S. bonds rated below Baa3 by Moody's and lower than BBB- by Standard & Poor's.

"We're only now starting to see a serious impact from the crisis in the euro-zone economy," said Christine Li, an economist at Moody's in London. "It's only a matter of time before larger companies feel the impact of squeezed credit conditions."

Moody's cut the long-term credit ratings on 194 western European companies this year and raised 73. In the same period last year, it lowered 217 and increased 494. Ratings cuts on mortgage bonds in Europe outpaced upgrades for the first time in the second quarter, Fitch Ratings said today.

The volume of loans to European companies is down by about 50 percent to $590 billion this year, compared with the same period of 2007, according to data compiled by Bloomberg.

The high-yield bond market is virtually shut, with one sale this year of 75 million euros by Strabag SA, the Austrian builder trying to expand into Russia and the Balkans. European borrowers issued $30.6 billion in the same period of 2007. U.S. companies have sold $60 billion this year, compared with $103 billion a year ago.

Credit markets froze on Aug. 9, 2007, as mounting losses on securities linked to subprime mortgages led banks to restrict overnight lending. The European Central Bank took the unprecedented step that day of offering unlimited cash and Paris- based BNP Paribas SA halted withdrawals from three investment funds because it couldn't value its holdings.

A year later, the difference between the interest rate banks charge for three-month euro-denominated loans relative to the overnight indexed swap rate shows cash still isn't easy. The so- called Libor-OIS spread was 76 basis points today, compared with a 68 basis-point average over the past year. In the first half of 2007 the spread averaged 8 basis points, or 0.08 percentage point.

European banks and financial institutions recorded $221 billion of losses and writedowns related to subprime debt since the start of 2007, compared with $250 billion in the U.S., according to Bloomberg data.

Companies in countries where real estate has been the main measure of wealth are suffering the most. As Spain's 15-year property boom ended, Martinsa became Europe's biggest bankruptcy since Parmalat Finanziaria SpA, Italy's largest food company, defaulted on 5.2 billion euros of debt in 2003. A Martinsa spokesman in Madrid, who declined to be named because of company policy, wouldn't comment.

"There's a strong link between the feel-good factor of a healthy housing market and consumer confidence," said Ed Stansfield, an economist at Capital Economics in London and a former adviser to the U.K. Treasury.

Confidence in the euro-region's economic outlook fell last month by the most since the Sept. 11 terrorist attacks, the Brussels-based European Commission said July 30. The ECB forecast in June that economic growth will slow to about 1.5 percent in 2009, from 1.8 percent this year and 2.7 percent in 2007.

In Europe, there is the potential for "things to be worse than in the U.S.," particularly in countries such as Ireland and Spain, said Holger Schmieding, the chief European economist at Bank of America Corp. in London.Bad news for borrowers may become good news for investment bankers who advise creditors and companies restructuring their debt.

"We're very, very busy," said Mark Fry, head of the London office of restructuring adviser Begbies Traynor. His working day has increased 40 percent from a year ago. "We're hiring new people and the staff are all working longer hours."

The International Monetary Fund predicted last night that the credit crunch would inflict two tough years on the British economy and warned that rising inflation left the Bank of England with little scope to cut interest rates in response.

In one of its regular health checks on Britain, the IMF said after 15 years of steady growth the economy was at risk from a series of interlocking shocks that would leave growth at 1.4% this year and 1.1% in 2009. In May, it forecast expansion of 1.75% in both years.

The report was released on the eve of today's decision on interest rates from the Bank of England, with the City expecting borrowing costs to be left unchanged at 5% for a fourth month. Despite pressure from retailers and the housing industry for cheaper borrowing, the IMF said it opposed cuts in bank rate at a time when inflationary pressure was so high and the government was allowing the budget deficit to rise.

In what it described as a "difficult context", the IMF said it was important for the Bank and the Treasury to ensure the credibility of economic policy. After repeatedly praising the performance of the economy during Labour's first decade in power, yesterday's report from the IMF board in Washington painted a far darker picture than in recent years.

In addition to highlighting rising inflation and slowing growth, the report said the UK had been struggling with two new international shocks: the turmoil in financial markets and the spiralling cost of fuel and food. A survey from the British Retail Consortium yesterday showed shop price inflation up from 2.5% to 3.2% last month, the highest in 18 months, with food prices nearly 10% higher than a year ago.

"The combined effects of these shocks raised uncertainty, increased inflation risks and compounded the ongoing correction in the domestic housing market," the fund said. "A run on Northern Rock ... raised the spectre of financial stability weakness feeding through to the real sector."

The IMF said the government was on course to breach its 2% inflation target for "an extended period" and was likely to break one of its two fiscal rules by allowing the public debt to breach 40% of GDP. "So far in 2008, evidence points to a sharp slowing in activity alongside high inflation," the IMF said. "Second-quarter growth was weak, forward-looking indicators are gloomy, sterling money market spreads remain elevated, unemployment has edged up and house prices are falling rapidly."

Philip Hammond MP, the shadow chief secretary to the Treasury, said: "Gordon Brown's economic incompetence is now famous around the world. His fiscal rules are in tatters, inflation is forecast to remain above target and his system for bank regulation failed its first serious test. The IMF report is a damning judgment on almost every aspect of his legacy as chancellor."

The IMF said it could find little evidence that higher food and fuel prices would trigger an upward spiral in the rate of inflation as wage increases remained subdued. But with inflation at 3.8%, it expressed concern that the public's expectation of future inflation had edged up.

"Given the outlook for inflation and the stance of fiscal policy, [IMF] directors saw little scope for monetary easing at present."Following a decade of what it called "sustained strong economic performance", the IMF said Britain was now facing "several concomitant shocks".

It added that the policy frameworks that had "underpinned this remarkable performance will be tested by lower growth, higher inflation from food and fuel price increases, ongoing strains in financial markets, rapid house price reversals and medium-term external imbalances. The financial sector strains have also triggered a broad-based effort to reform the financial stability framework."

The chancellor, Alistair Darling, has already said the government would allow borrowing to rise in the downturn, even if that meant breaching the 40% ceiling

British house prices fell for a sixth month running in July to an average of £177,351 - a price in line with the average in June 2006.

According to HBOS, Britain's biggest mortgage lender, properties are changing hands for 11 per cent less than the average £199,600 that they were at the last peak in August 2007. The rate of decline is now sharper than in the last housing slump in the early 1990s.

According to the Halifax House Price Index released today, prices fell 1.7 per cent in July to a UK average of £177, 351. The survey fits with recent data from rival Nationwide, which found also found that prices were 1.7 per cent lower in July. Last month was the fourth in a row in which price falls were at least 1.5 per cent, bringing the annual rate in the July quarter to 8.8 per cent - a steeper decline than the 8.5 per cent the market had expected.

Suren Thiru, the Halifax economist, said the current strain on household income from rising prices and higher hurdles to obtain mortgage finance as a result of the credit crunch was preventing potential housebuyers’ ability to enter the market and consequently depressing prices.

Recent Bank of England data showed the number of mortgages approved in the second quarter was 60 per cent lower than in the same period of 2007. Halifax pointed out in an attempt to put the current gloom in perspective that the average house price in July was £44,980 higher than in July 2003, and £104,888 or 145% higher than a decade ago. The rate of decline over the month was also less than the 1.9 per cent fall in June and 2.5 per cent in May.

Howard Archer, economist at Global Insight, said prices would continue to deteriorate in 2008. "It seems odds-on that house prices will continue to head rapidly south, given that the Bank of England reported extremely low mortgage approvals for house purchases in June, while latest survey evidence shows that house sales are depressed, buyer interest is weak, it is taking longer to sell a house, and sellers are achieving a falling percentage of their asking price," he said.

He said potential buyers were being kept away by the grim economic outlook and inflation pressures as well as the rising cost of finance and higher deposit levels - a particular problem for first-time buyers.

"It seems unlikely that the Bank of England will cut interest rates in the near term at least. Indeed, it is possible that the Bank of England's next move could be to raise interest rates, which would clearly be very bad news for the housing market," he said. "Very negative housing market sentiment also heightens the risk that house prices will fall sharply over the next couple of years", he added.

Speculation that the Government might defer or suspend stamp duty could keep more people out of the market in the short term, he said. Global Insight today forecast UK house prices to fall by 15 per cent this year and 12 per cent in 2009 to a low of £140,104 in 2010.

The serious problems in the housing market were underlined today as official figures showed that orders for new homes by construction groups between April and May plunged 35%. Overall construction orders fell by 21 per cent.

Housebuilders have been hit hard as the seizure in the mortgage market has dampened the number of buyers, exacerbating house price falls. Some developers have even been forced to resort to threatening to sue prospective buyers who decide to abandon their purchase and forego their deposit.

One housebuilder is offering to double the deposit saved by first-time buyers in an effort to lure more buyers to the market.The new figures follow dismal news from the influential PMI survey of the construction sector earlier this week that showed that construction activity contracted at the sharpest rate since the survey began in 1997.

Howard Archer, of Global Insight, the economic consultancy, said: "There can therefore be little doubt that the construction sector is now firmly in recession. Indeed, the construction sector looks to be in for an extended, very difficult time.

"This reinforces our belief that the overall economy is more likely than not to contract in the second half of 2008, even allowing for the fact that the construction sector's share of national output is relatively limited at some 6 per cent. "

The heads of Britain's biggest mortgage lenders may not be trumpeting it from the rooftops, but in private they are all agreed. Homeowners will never have it so good again.

"People will look back at the last decade as the halcyon days of cheap mortgages," one senior banker said. "It's not going to get like that again." Call it the Northern Rock boom. Debt was cheap and people's appetite for it was insatiable. Leverage was not risk, but an aspiration.

The bigger the debt, the larger the return. In the corporate world, private equity parlayed easy money by making "more efficient" use of companies' balance sheets - in other words, loading it with debt. For the general public, mortgages were where ambitions collided with the credit binge.

It took a brash former building society from Newcastle to make it happen, though. Northern Rock pioneered the affordability model of mortgage lending. In the early 1990s, borrowers would be lucky to be offered a loan of three times their salary. By the time Northern Rock was finished, six times was almost the norm.

As the rivals caught up, Northern Rock became even more intrepid, developing its now infamous "Together" offer - a mortgage of up to 125pc of the value of a home at a time when a 90pc loan-to-value ratio was considered racy. Together relied on two things, which themselves required blind optimism. First, that debt would remain cheap and, second, that house prices would continue to rise.

It is no coincidence that Northern Rock is the UK's worst casualty of the credit crunch. Chief executive Adam Applegarth harnessed his growth model to the wholesale markets, where funding was unfettered, and turned his back on deposits, only to witness the markets seize up and his money supply cut off - the first step on the lender's humiliating route to nationalisation.

Northern Rock neatly bookends the mortgage boom, but the consequences will long outlast the now state-owned bank. Britain is going through the first convulsions of change now.

As early as last October, Andy Hornby, chief executive of the UK's largest lender, HBOS, which owns Halifax, said: "The mortgage market is about to undergo a fundamental shift." Hector Sants, chief executive of the Financial Services Authority, said: "I don't think the markets here will ever return to the way they were... Easy credit is not necessarily good for either consumers or the economy in the long term."

The message is clear. Expensive mortgages are here to stay, and the numbers bear this out. First, availability has dried up. According to the Council of Mortgage Lenders, net mortgage lending is on course to halve and the volume of housing transactions to fall by 30pc to 40pc this year. Hornby believes next year will be even worse.

Data compiled by Credit Suisse shows that there were 17,300 mortgage products on the market in June 2007. Today there are just 4,000. Last year, 100 financial institutions were vying for mortgage business. Now, almost all net new lending is provided by just five banks - Lloyds TSB, Abbey, HBOS, HSBC, Barclays and Royal Bank of Scotland. Building societies actually took £526m out of the market in June.

It's not just that there is less availability. Mortgages are also less affordable. According to the Bank of England, the average mortgage rate of 6.63pc is now at its highest since 2000, despite interest rates being cut by three quarter of a percentage point since July last year.

Money markets are to blame for the bulk of the increase, as the banks' own cost of funding has soared in the credit crisis, but lenders have also managed to improve their profit margins as competition has fallen away.Recent Bank of England data shows that the spread over base rate is now about 150 points, according to Credit Suisse's credit availability monitor - back at levels last seen in 1999.

Last year, the spread was 30 to 40 basis points at best. "At that level, banks were barely covering their costs," says Credit Suisse analyst Jonathan Pierce. In essence, mortgages had become unsustainably cheap. Lenders, Northern Rock in particular, were using short-term but cut-price wholesale markets to fund on a massive scale.

Sir James Crosby, in his report into mortgage finance for the Treasury, noted that British institutions used the money markets for £78bn of new mortgages in 2006 - the last great boom year. "By 2006, such funding equated to around two thirds of net new mortgage lending," Sir James said.

The markets are now shut. Not only are investors refusing to provide the banks with the money to lend on, but they want their money back - at the rate of £40bn a year, Sir James reckons. The credit squeeze is not about to loosen its grip.

When it came to wholesale funding, Northern Rock was again the archetype. With just 76 branches and little interest in more expensive customer deposits, the bank kept its cost base artificially low. The more mortgages it sold, the more efficient it became.

Only, it was a model built on sand. When the wholesale markets seized, Northern Rock could no longer fund affordably and its mortgages became loss-making - as the negative interest margin of -0.13pc disclosed with this week's results makes clear. Northern Rock may not have been to blame for the sub-prime crisis that closed the money markets down, but its model was so high-octane that it never had time to adjust.

Northern Rock was the extreme, but where it went the rest of the market followed. In fact, mortgages had become so cheap by 2006 that some lenders - such as Lloyds, Abbey and HSBC - decided to all but pull out of the market.

Others, like HBOS, tried to match Northern Rock before belatedly switching their focus from volume to profit margin. Far from an example of bank profiteering, signs that margins in the mortgage market are improving are signs of health. Risk is being repriced to reflect what it should have been.

The Massachusetts state treasurer's office confirmed that the state's pension board dismissed Legg Mason Inc. and four other managers of the pension's U.S. equity assets as a result of their underpeformance.

The decision is the latest blow to the reputation of Bill Miller, the Legg Mason star who has seen his reputation suffer as his picks -- including Fannie Mae, Freddie Mac, Bear Stearns Cos. and Citigroup Inc. -- sour. The board said Wednesday that its investment in Legg Mason Value Trust is down 27.61% this year, an underperformance of 15.7 percentage points and the worst of the dismissed managers. The pension had $638 million of assets in the fund as of June 30.

On July 28, Legg Mason said Mr. Miller had outperformed the Standard & Poor's 500 index by six percentage points since July 15, but apparently it was too little, too late for the board. A representative for Legg Mason wasn't immediately available for comment.

The Massachusetts Pension Reserves Investment Management Board moved the assets managed by the funds to a Russell 3000 Index portfolio managed by State Street Global Advisors, a unit of State Street Corp.

Besides Legg Mason, the other dismissed firms are fellow S&P 500 active managers Gardner Lewis Asset Management and NWQ Investment Management as well as small-cap managers Mazama Capital Management Inc. and Ariel Capital Management. The assets in the other four funds totaled $1.18 billion on June 30. In total, the pension system has $14.76 billion in U.S. equity asset

Gov. Arnold Schwarzenegger announced Wednesday that he would not sign any bills lawmakers send him until they pass a budget and would veto measures already on his desk before they can become law.

"There is no excuse for the Legislature's failure to reach a compromise and to send me a budget," Schwarzenegger said at a news conference, more than a month into the new fiscal year. "Until the Legislature passes a budget that I can sign, I will not sign any bills that reach my desk."

Under state law, bills sitting on the governor's desk for more than 12 days would automatically become law. Schwarzenegger said he would keep that from happening by exercising his veto if necessary: "I will veto anything on my desk." "Some good bills will fail," he said. "But we do not have the luxury of stretching out this process any longer."

There are 13 bills on the governor's desk now, all of which originated in the Senate. Senate leaders said they would withdraw them before they could be vetoed. The bills could be resubmitted before the Aug. 31 end of the legislative session.

Last week, Schwarzenegger ordered officials to drop the salaries of most of the state's 235,000 workers to the federal minimum wage of $6.55 an hour until a budget is passed; then they would get the rest of their salaries. The governor also laid off more than 10,000 part-time and seasonal workers, saying the state was experiencing a cash crunch

Legislators are going without their salaries but will get back pay when a budget is in place. The governor said Wednesday that state law should be changed to force lawmakers to forfeit that money. "They shouldn't be paid, and they should never get that money back," Schwarzenegger said.

Senate President Pro Tem Don Perata (D-Oakland) predicted that the governor's plan not to sign bills would backfire. "My fear is that simply creates another tension between the administration and the Legislature that is really unnecessary," Perata said. "It's like we are escalating the wrong war."

Republicans, who are in the legislative minority, were less troubled. "Great," said Sen. Jeff Denham (R-Atwater). "Many of the bills the Legislature passes do California more harm than good." Eight of the 13 bills before Schwarzenegger were written by Republicans.

They would, among other things, exempt law enforcement from a ban on weapons in state game refuges; deny dental licenses to people federally registered as sex offenders; and allow the Purple Feet Wine Boutique and Tasting Room to sell beer and wine at functions sanctioned by the city of Dana Point.

Others would revamp the California Seed Advisory Board and allow public safety officials to wear military decorations on certain holidays. A Democratic bill would update state law enforcement training programs to include a course on interacting with autistic people.

Schwarzenegger continued to warn Wednesday that the state is in danger of running out of cash if a budget is not approved soon. Administration officials say that, without a spending plan, Wall Street may refuse to provide the short-term loans that California typically relies on to remain solvent until the usual flood of tax receipts arrives in the spring.

But California Controller John Chiang said Wednesday that the state has enough money to pay its bills into October, based on new, better-than-expected estimates of cash flow in the state treasury. Chiang said the state worker layoffs and salary decreases are therefore unnecessary. The controller, who manages the state payroll, has said he will not execute the governor's pay cuts.

"In light of our cash flow improvements, I respectfully urge the governor to reconsider his executive order," Chiang said in a statement.

At least 29 states plus the District of Columbia, including several of the nation’s largest states, faced an estimated $48 billion in combined shortfalls in their budgets for fiscal year 2009 (which began July 1, 2008 in most states.) At least three other states expect budget problems in fiscal year 2010.

In general, states closed these budget gaps through some combination of spending cuts, use of reserves or revenue increases when they adopted a fiscal year 2009 budget. At this point in the year, most states have already adopted those budgets. In order to present a complete picture of the impact of the current economic downturn on state finances, we report both the gaps that have been closed and those that will be closed in the future.

The bursting of the housing bubble has reduced state sales tax revenue collections from sales of furniture, appliances, construction materials, and the like. Weakening consumption of other products has also cut into sales tax revenues. Property tax revenues have also been affected, and local governments will be looking to states to help address the squeeze on local and education budgets.

And if the employment situation continues to deteriorate, income tax revenues will weaken and there will be further downward pressure on sales tax revenues as consumers become reluctant or unable to spend. The vast majority of states cannot run a deficit or borrow to cover their operating expenditures.

As a result, states have three primary actions they can take during a fiscal crisis: they can draw down available reserves, they can cut expenditures, or they can raise taxes. States already have begun drawing down reserves; the remaining reserves are not sufficient to allow states to weather a significant downturn or recession.

The other alternatives — spending cuts and tax increases — can further slow a state’s economy during a downturn and contribute to the further slowing of the national economy, as well. The Center on Budget and Policy Priorities currently is monitoring state fiscal reports and is in touch with state officials and/or relevant state nonprofit organizations in the 50 states and DC. The fiscal situation appears to be as follows.

Over half of the states have faced problems with their FY2009 budgets.

The 29 states in which revenues were expected to fall short of the amount needed to support current services in fiscal year 2009 are Alabama, Arkansas, Arizona, California, Connecticut, Delaware, Florida, Georgia, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Nevada, New Hampshire, New Jersey, New York, Ohio, Oklahoma, Rhode Island, South Carolina, Tennessee, Vermont, Virginia, and Wisconsin. In addition, the District of Columbia closed a shortfall in fiscal year 2009. The budget gaps totaled $47.6 to $49.2 billion, averaging 9.3 percent to 9.7 percent of these states’ general fund budgets. (See Table 1.) California — the nation’s largest state — faced the largest budget gap. The shortfalls that states other than California faced averaged 6.2 percent to 6.7 percent of these states’ general fund budgets.

Analysts in three other states — Missouri, Texas, and Washington — are projecting budget gaps a little further down the road, in FY2010 and beyond.

This brings the total number of states identified as facing budget gaps to 32 — close to two-thirds of all states. Most states have addressed the FY2009 budget gaps identified here. However, new budget gaps in these and other states are likely to develop as state revenue forecasts are updated during the year.

Gov. Chris Gregoire did Monday what families and businesses have been doing for months: She ordered cuts in travel and buying gasoline, a hiring freeze and a lid on major purchases for most state agencies. The effort is expected to save $90 million, making up for an unexpected $60 million drop in revenue in June.

The lost income came from a slowdown in the housing market and lower business taxes than expected. "I am asking each of you to step up your efforts to increase savings. I ask that you be creative and take action now," Gregoire said in a memo to state employees.

"The high price of energy is hurting our businesses and our families. Anything we can do to reduce fuel consumption will ease the burden on our budget and on taxpayers." The order provides exemptions for public safety agencies, including the State Patrol and prisons.

The order to cut expenses involves only departments directly under the Democratic governor's control. But in her letter, Gregoire, who is wrapping up her first term as governor, said she is also asking others, including elected officials and college presidents, to make similar cuts.

"The governor is clear that we not do anything to impact public service or public safety," said spokesman Pearse Edwards. The measures suggest the governor might be looking ahead to a serious deficit in the next budget. Gregoire and her staff have disputed the number, but some budget minders say the gap could reach $2.7 billion.

Her announced belt tightening immediately drew criticism from opponents. Republican gubernatorial challenger Dino Rossi called the reductions too little and too late to make up for earlier spending. "I'm glad that Governor Gregoire has started to recognize the budget crisis she's created.

She had to know that by increasing spending 33 percent in her first term she was heading the state toward a budget deficit," Rossi said. He said his restrictions would be even stricter.

"In addition to a hiring freeze, we should also freeze salary increases for politically appointed state employees. Further, Governor Gregoire should suspend salary negotiations with state employee groups over pay increases until we know the full extent of our deficit next year," Rossi said.

He warned that Gregoire might suggest a tax increase, though she has said that she will not do that.Gregoire maintains that the state economy is strong and is holding up better than the national economy. She points to a Forbes article that ranks Washington as the third-best state for business.

But Mary Lane, state GOP communications adviser, said national woes are starting to hit home, including a slump in the housing market, layoffs at Starbucks and Washington Mutual and an increase in the state's unemployment rate.

"Judging by her frequent use of the everything's-fine rhetoric, the governor apparently believes this is a winning message. But something tells me it's not going to gain much traction with voters who are worried about their economic future," said Lane.

Ilargi: Interesting background from The Village Voice. Do read the whole artcice.

There are as many starting points for the mortgage meltdown as there are fears about how far it has yet to go, but one decisive point of departure is the final years of the Clinton administration.

Then, a kid from Queens without any real banking or real-estate experience was the only man in Washington with the power to regulate the giants of home finance, the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), better known as Fannie Mae and Freddie Mac.

Andrew Cuomo, the youngest Housing and Urban Development secretary in history, made a series of decisions between 1997 and 2001 that gave birth to the country's current crisis. He took actions that—in combination with many other factors—helped plunge Fannie and Freddie into the subprime markets without putting in place the means to monitor their increasingly risky investments.

He turned the Federal Housing Administration mortgage program into a sweetheart lender with sky-high loan ceilings and no money down, and he legalized what a federal judge has branded "kickbacks" to brokers that have fueled the sale of overpriced and unsupportable loans. Three to four million families are now facing foreclosure, and Cuomo is one of the reasons why.

What he did is important—not just because of what it tells us about how we got in this hole, but because of what it says about New York's attorney general, who has been trying for months to don a white hat in the subprime scandal, pursuing cases against banks, appraisers, brokers, rating agencies, and multitrillion-dollar, quasi-public Fannie and Freddie.

It all starts, as the headlines of recent weeks do, with these two giant banks. But in the hubbub about their bailout, few have noticed that the only federal agency with the power to regulate what Cuomo has called "the gods of Washington" was HUD.

Congress granted that power in 1992, so there were only four pre-crisis secretaries at the notoriously political agency that had the ability to rein in Fannie and Freddie: ex–Texas mayor Henry Cisneros and Bush confidante Alfonso Jackson, who were driven from office by criminal investigations; Mel Martinez, who left to chase a U.S. Senate seat in Florida; and Cuomo, who used the agency as a launching pad for his disastrous 2002 gubernatorial candidacy.

With that many pols at the helm, it's no wonder that most analysts have portrayed Fannie and Freddie as if they were unregulated renegades, and rarely mentioned HUD in the ongoing finger-pointing exercise that has ranged, appropriately enough, from Wall Street to Alan Greenspan.

But the near-collapse of these dual pillars in recent weeks is rooted in the HUD junkyard, where every Cuomo decision discussed here was later ratified by his Bush successors. And that's not an accident: Perhaps the only domestic issue George Bush and Bill Clinton were in complete agreement about was maximizing home ownership, each trying to lay claim to a record percentage of homeowners, and both describing their efforts as a boon to blacks and Hispanics.

HUD, Fannie, and Freddie were their instruments, and, as is now apparent, the more unsavory the means, the greater the growth. But, as Paul Krugman noted in the Times recently, "homeownership isn't for everyone," adding that as many as 10 million of the new buyers are stuck now with negative home equity—meaning that with falling house prices, their mortgages exceed the value of their homes.

So many others have gone through foreclosure that there's been a net loss in home ownership since 1998. It is also worth remembering that the motive for this bipartisan ownership expansion probably had more to do with the legion of lobbyists working for lenders, brokers, and Wall Street than an effort to walk in MLK's footsteps.

Each mortgage was a commodity that could be sold again and again—from the brokers to the bankers to the securities market. If, at the bottom of this pyramid, the borrower collapsed under the weight of his mortgage's impossible terms, the home could be repackaged a second or a third time and either refinanced or dumped on a new victim.

Those are the interests that surrounded Cuomo, who did more to set these forces of unregulated expansion in motion than any other secretary and then boasted about it, presenting his initiatives as crusades for racial and social justice. Cuomo was shrewd enough at the age of 24 to manage his father's successful 1982 gubernatorial campaign, and to help run his government.

The only statewide campaign his father ever lost was in 1994—when Andrew was at HUD as an assistant secretary and couldn't manage it. He is as quick and as silver-tongued as the elder Cuomo he sounds so much like, but HUD was a test of his depth, so he found himself balancing competing forces and making deals on a grander scale than he was used to in Albany. We now know that he was also making history.

The Bank of Korea raised its benchmark interest rate by a quarter point to the highest in almost eight years, judging the fastest inflation in a decade is a greater threat than slowing economic growth. Governor Lee Seong Tae increased the seven-day repurchase rate to 5.25 percent in Seoul today, as forecast by six of 19 economists surveyed by Bloomberg News.

The rest predicted no adjustment. Lee joins policy makers in India, Indonesia, Taiwan, Thailand and the Philippines in boosting borrowing costs this year as soaring fuel and food costs fan inflation across Asia. South Korean stocks fell on concern higher rates will curb an economy already growing at the slowest pace in more than a year as rising prices damp spending and squeeze corporate profits.

"Today's decision was a prudent, necessary step to ensure that inflationary expectations remain under control," said Robert Subbaraman, chief Asia economist at Lehman Brothers Holdings Inc. in Hong Kong. "It will be a one-shot increase: policy focus will start to move away from inflation towards growth concerns later this year."

Consumer prices climbed 5.9 percent in July from a year earlier, exceeding the central bank's target for the ninth straight month. The bank aims to keep inflation between 2.5 percent and 3.5 percent, on average, for the three years to 2009."This action should contribute to containing inflation expectations," the central bank said in a statement.

The government said earlier today the economy is weakening as consumer spending slows. "We need to place priority in stabilizing the ordinary people's lives and creating more jobs," the finance ministry said in its monthly report. "Today's decision is likely to do more harm than good," said Frederic Neumann, an economist at HSBC Holdings Plc in Hong Kong. "Economic growth already looks set to decelerate sharply over the second half of the year."

Ssangyong Motor Co., the South Korean unit of China's biggest automaker, reported that domestic sales slumped 67 percent in June from a year earlier. Local sales at Hyundai Motor Co., Korea's largest carmaker, slipped 0.6 percent in the second quarter.

Households were at their most pessimistic in almost four years in June and manufacturers' confidence for August sank to the lowest in three years. Factory output increased 6.7 percent in June from a year earlier, the smallest gain in nine months. Exacerbating inflation pressures, the won's 8 percent decline against the dollar has made imported goods more expensive. Import prices surged 49 percent in June from a year ago, the biggest gain in more than 10 years.

"The rate hike should partly help support the currency," Lehman's Subbaraman said. "The weakening won has been adding more import-price pressure and today's rate increase should help ease that." The central bank is estimated to have spent more than $12 billion since the end of May to boost the value of the won and cool inflation, said Jung Chan Ho, a currency dealer at Shinhan Bank in Seoul.

"The pace of intervention in itself was clearly unsustainable over the long term, given the BOK's limited reserve pool," HSBC's Neumman said. "The hike in the base rate should therefore be interpreted as a complement to the authorities' policy of supporting the exchange rate." The Bank of Korea also boosted the interest rate on the funds it makes available for loans to small businesses by a quarter-point to 3.25 percen

The rise of India's economy is often compared to the progress of an elephant - slow and plodding when compared with the dragon of China, but invested with a heavy sense of inevitability. In the past six months, however, the elephant has performed a disconcerting about-turn.

In January India appeared to be in excellent shape. Annual GDP growth was close to 9 per cent, corporate profitability had risen by 20 per cent in a year and the stock market had surged 50 per cent. The elephant was trundling along at full speed. Seven months later, Bombay's benchmark Sensex index has lost 40 per cent of its value and foreign investors are fleeing the market.

Andrew Holland, head of proprietary trading at Merrill Lynch in Bombay, said: “This time last year the talk was of India decoupling from the troubles of the rest of the world economy. Now it's clear that India has its own problems. It has gone from hero to zero.”

The bad news has been unrelenting. The rupee has plunged amid fears that India's fiscal deficit is spiralling out of control. In response, the country's fragile coalition Government has made massive populist handouts in the run-up to a general election that must be held before May.

Fitch, the ratings agency, recently downgraded the outlook on India's sovereign debt, taking it only one step from junk status.Goldman Sachs has just lowered its GDP growth forecast for 2008 to 7.5 per cent - a rude awakening for a nation that was gunning for double figures.

Robert Prior-Wandesforde, the HSBC economist, said: “Just as many forecasters and markets were too optimistic in 2005-07, effectively running with the view that whatever China could do, India could do better, there are now some that are suggesting that it can do nothing right.”

In the teeth of this downturn, interest rates were increased this week for the third time in two months, to 9 per cent, a move that will further dent the spending power of India's beleaguered consumers. There is little chance of the Reserve Bank of India softening its new ultra-hawkish stance soon, either. Inflation is running at close to 12 per cent, more than double the unofficial 5.5 per cent target and up threefold since the start of the year.

Last Wednesday's quarterly figures from Tata Motors, the new owner of Land Rover and Jaguar, illustrated how companies are suffering: profits slumped 30 per cent as the price of steel soared. Amid the gloom, the sub-continent's cheerleaders are spelling out afresh that India's rise is not inevitable.

Jim O'Neill, the Goldman Sachs chief economist, is perhaps the most important evangelist India has. He coined the now-famous acronym Bric (Brazil, Russia, India, China) in a paper that spelled out the potential of the emerging world giants in 2003.It audaciously suggested that, under certain conditions, India's economy could surge past that of the United States by 2050.

“Many clients have often regarded this projection as a fact,” Mr O'Neill said, making clear that he does not. He has written a new report emphasising that India's advance to economic superpower status depends on radical improvements in areas ranging from fiscal discipline to primary education standards to crop yields.

In the shorter term India must pray that the global oil market subsides. The country imports 70 per cent of the oil it uses and heavily subsidises domestic fuel prices to keep them within reach of its vast poor population. “Given the inflation challenge, the fiscal and current account position, one might say oil prices are the most critical thing for India in the next six months or so,” Mr O'Neill said. “Oil at $150 would be quite bad news.”

Meanwhile, the elephant analogy still seems apt - after all, those who get on an elephant should expect a bumpy ride.“This is a long-term growth story,” Alan Rosling, an executive director at Tata & Sons, said. “As ever in India, there will be plenty of messiness along the way.”

16 comments:

That sounds reasonable ilargi, in fact a couple days ago I was thinking of suggesting here, that investment opportunity would be great in security, prison and related service and equipment companies. It does look like the last bits of the wall between politics and business are being removes.

I had observed before that after years of the executive branch seizing tyrannical power, in the last 6 months the baton has been passed to the Federal Reserve. Are you predicting that Bush is intentionally ceding control over the non-violent parts of the federal budget to Fed/Goldman by pleading poverty, so that by the next inauguration Obama will have no discretion to spend on anything except war and spying? That sounds like the old World Bank/IMF/Friedman tag team.

It's far worse than that, Anonymous Reader. Even the cash you have in hand is not really what you think it is.

Originally cash was a paper receipt exchangeable for tangible assets held by a bank. Those assets were frequently gold and/or silver although throughout history some other assets were used.

With the adoption of fractional reserve lending, the presence of assets fell below the actual possible demand to redeem those receipts. With the adoption of deficit spending, we began to borrow against what tangible reserves we had. With the closing of the gold window, the paper receipts were fully decoupled from tangible assets and were instead linked to the slave labor of the workers of the United States although this was euphemistically called the "full faith and credit of the United States".

There are two remaining pieces of the puzzle. The first is "where is our gold" and Katherine Fitts has been asking that question rather pointedly for a while now. Trust me when I say that the banking elite knows exactly where "our" gold is. The second piece of the puzzle is how the banking elite restore the power and separation from the common man that was the norm through the dark and middle ages. This is being done by piling up debt, in the public's name, so deep that no person can ever pay off their share.

At that point we have no tangible assets and we "owe our souls to the company store", to borrow a phrase.

I believe that this is the point that Ilargi makes - as we watch fascism re-emerge in its true form (a combined government/economic system focused around the symbiotic relationships between the state and corporations within the state), individual human beings will become increasingly subordinated, via debt, to the whims to their corporate masters.

Some people think this is about race. It's not. It's about power and subjugation. And they will subjugate any and all that they can, regardless of skin color.

"“Virtually everybody was frankly slow in recognizing that we were on the cusp of a really draconian crisis,” said E. Gerald Corrigan, a managing director at Goldman Sachs and a chairman of the Counterparty Risk Management Policy Group III" -

It does sound as if- some of those involved at high levels are genuinely puzzled about it all; and are puppets themselves. Big big report, "explaining"- that they don't seem to understand.

The logical conclusion would be - these people do not understand what they are doing. Ergo- we should find OTHER people, to do these jobs. So, of course- we keep giving these people, who admit they do not understand how anything works, or what happens next- more and more control and power over the financial systems.

Every time I read the Debt Rattle I become more... rattled! Geez, this is like a baaaadddd dream, aka nightmare.

I'm really worried about 401Ks, IRAs, pensions. What can one (me) do when each day I see my balance decline? Withdraw now and 'take the loss' AND pay penalties AND taxes while huge financial institutions get to 'write off' their losses vis-a-vis government (read, taxpayer) bailout?

I remember a time when I wanted to be older. Well, I'm there again. I fear there will be no collecting of the Wells Fargo pension by the time I'm 55 (3 long years away) or that my IRA will even be taxable, much less withdrawalable (as in a balance at all).

This is not looking good folks. All the 'HELP' is going to institutions, not individuals. What would really help a lot of us NOW would be no penalty and no tax on w/d 401Ks and IRAs. Let's get real... we're not saving for our future. We're saving for the ability to pay future taxes.

Should I stay or should I go? Help me out here, whaddya say? I think I should be allowed, tax & penalty free, to reallocate my investments out of lala land into reality. I'm thinking rain collection, solar water heating and PV.

"these people do not understand what they are doing. Ergo- we should find OTHER people, to do these jobs. So, of course- we keep giving these people, who admit they do not understand how anything works, or what happens next- more and more control and power over the financial systems."

After admitting their cluelessness, they make the stunning declaration that they, in effect, should be self-regulating, and their self-regulation will actually be more stringent than if they were regulated from without. Of course, implied in that statement is the notion that they can't be regulated by outsiders because they, the Wall Street insiders, are the only ones who really understand finance well enough to provide effective oversight. But, they will graciously allow us to bail out their sinking ship at taxpayer expense.

"After admitting their cluelessness, they make the stunning declaration that they, in effect, should be self-regulating, and their self-regulation will actually be more stringent than if they were regulated from without."

Exactly. Isn't it absolutely fabulous? George Orwell has to be purple with envy.

Edgy- some advice- about advice. The more freely it's given, the more you should beware. Tolkien nailed it nicely: Frodo complains, "It is said, go not to the Elves for advice; for they will say both no, and yes." And the Elf responds, "Even from the wise to the wise, advice is a perilous thing."

Any intelligent and responsible person would be very very hesitant in this world to suggest what someone else should do. Clearly- there are no clear answers.

Greenpa, I may have to disagree when you say Edgy- some advice- about advice. The more freely it's given, the more you should beware. .

Edgy, here's my advice (which I assume you will evaluate and discard if necessary - probably goes without saying):

Follow the money. For example, if your mutual fund salesman says to stay in bank stocks because their yields are really high right now, and hell, even if those dividends are cut, at least your salesman got his commission, then maybe you should reconsider that investment. If, on the other hand, you read the articles posted here and the analysis from S&I and, increasingly, others ... and all the contradicting articles you read seems to sound a little hollow ... and you find that nobody here is trying to sell you anything (ok, maybe there's a tip jar and some reading recommendations but no overt selling of anything), then maybe you will come to same conclusion as I did. Of course, in my case, I actually know these two mythical figures. For what it's worth (and they will probably be embarrassed to have me write this), they are every bit as genuine, intelligent and passionate in person as they are in writing. I recently moved from eastern Ontario but if/when I return to visit, they will be first on the list of people to visit.

Just one piece of specific financial advice, to restate the overriding philosophy of S&I and those who frequent Denninger's TicketForum: during deflation, cash is priceless, not worthless.

Greenpa - I liked your reply... the fairy tale aspect immediately brought a smile as the thought of such a reality did I imagine.

I am very slow to change in some areas, quicker in others. I must say, though, the learning occuring these past 4 years seems to be slowing me further. The opposite is more what I thought would happen. I don't like to be rushed and that's just what all this information, now knowledge, feels like. The energy, climate, financial, food, water and population issues all seem to be both converging and peaking. It's as though the more I know, the less I want to do.

And, yet, I enjoy working the land; creating vegetable/flower gardens; composting; planting fruit trees. Lots of other projects lined up - rainwater collection, solar hot water and PV the next big ones.

OUTTACONTROL - I like what you wrote too. I have no illusions about my broker. High confidence in what she knows. Less so in what she doesn't; which, at this point, not sure who would. What really peeves me is how much I will be taxed/penalized for moving my investments from a 'government approved' to a 'not approved' vehicle. Government has proved its inability to be the guardian for the people for whom it was created. I, as an individual and real person, should have absolute control over that which is mine.

For example, AFAIK, if you withdraw from your retirement and if penalties and taxes are due, then they will be collected from the proceeds directly from the financial institution. I want the ability to protest both by not paying either. IMO, government has too much control.